How ARMs work
From the Lender’s side, the whole point of an ARM is to move
interest-rate-risk to the Borrower, off the Lender. Lenders want their
loans to pay more to them if rates go up in the future.
From the Borrower’s side, the same payment at a lower start-rate allows
them to borrow more loan, i.e. increases their “buying power”. ARMs extend
your reach. The borrower trades their ability to borrow more now, for the
possibility of having to pay a higher payment later.
The “formula” used to understand how the rates can change in the future:
Index + Margin (within caps) = Rate
The Index is an expression of the economy, because it will change in
the future as the general economy changes. It’s simply a number that
represents where the economy is at, it’s the number the loan and its
interest rate is “pegged” to. These index numbers have to be readily
available to the borrower, (they are published in the Wall Street
Journal), and however often the Index changes has NOTHING to do with how
often an ARM loan adjusts.
The Margin is how much more than the index/economy the borrower will pay
to the Lender, i.e. as the economy changes, the Lender will get that
change, up or down, plus the margin, subject to caps or limits.
“Caps” are the limits that keep the loan interest rate from changing
drastically, i.e.
the caps keep the payment from going up or down too much, to a level the
borrower can’t afford the payment/loan..
Here’s a good chart that shows the most common indexes over the last 10
years:
http://www.chevychasewholesale.com/pdf/historicalchart3.pdf
Common Indexes
COFI: It’s the Cost of Funds Index for the 11th District of the
Federal Home Loan Bank Board (the government-sponsored lender to the
Savings Banks in CA AZ, NV – which just happens to be the most expensive
FHLBB district). It’s the VERY stable index - it’s based on independent,
not government, debt, as it’s the rate charged to the Savings Banks which
are profit-motivated borrowers, thus the index/lender is motivated to keep
a stable/low rate. This index changes monthly.
1-year Treasury Security index: the usual, historically most-used
index for home loans, it’s the weighted average yield on all US government
debt that matures 12 months from now. It’s dynamic level is average;
government debt is auctioned off every week, so the index changes weekly,
and the auction system means the borrower/”we the people” have to pay what
lenders/buyers require, i.e. we have no ability to negotiate/pay a lower
rate. Thus it truly demonstrates which direction general interest rates
are moving.
12MTA: This monthly index is the last 12 month’s average of the
1-year Treasury Security index, and is Lender-designed to attract
borrowers in a low or after-low rate environment; it has the same dynamic
as the T Security index, and the highs and lows match that index, it just
lags those moves and thus looks better when rates have started to move up.
Lenders claim the averaging gives it a slightly lower performance, but
that’s only true because rates have historically been lower.
LIBOR (London Industrial Board ): This Index has been used by
Commercial Banks in the past, as it increases their yield, based on their
higher-risk-than-home-loans and it is thus potentially more risky for the
borrower; it’s a European “prime rate” and is VERY dynamic, i.e. it moves
quicker, stays higher and lower at the extremes, but is up first and more
now that rates are going up; it’s used by home lenders to justify the
lowest start rates, and home lenders usually include high caps or limits
to the loan rate change, such that it is NOT (in my opinion) a good index
to base the loan on, after the initial fixed period.
Prime Rate: This is the rate Commercial Bank offer to their best
commercial customers, and to all the rest of us with a margin or increase
on top of it.
ARM Terms
The factors in the ARM that effect your payments and how the loan will
work in the future are:
- the Adjustment term: how often the rate changes
- how much the Margin adds, above the index
- the Caps or limits to rate and thus payment changes
- If any, the Term or duration of a fixed rate and payment period
The rate and payment on an ARM will change at a certain time after the
month of the first payment, which is not the month your loan closed in.
The Lender will be sending you a notice of the new numbers about 45 days
prior to that change date.
Available Adjustment Terms
There are many different ARM terms and ARM types. This
flexibility ensures that there's an ARM for almost every situation.
When looking at an ARM you need to pay attention to the:
- Loan term - All Adjustable Rate Mortgages come in 15, 20 or
25 year terms. Some even come in 40 year terms.
- The fixed period - ARMs usually start out with a certain
amount of time during which the interest rate can't change.
- The adjustment period - This number represents the frequency
that the the loan can adjust.
Here is just an example of the type of ARM terms available:
- Monthly ARMs change monthly
- 6-mo ARMs change every six months
- 12-mo ARM is the same as a 1-year ARM and changes annually
- 3/1 ARM is a 1-year ARM fixed for the first three years then adjusts
annually thereafter
- 3/6-month ARM is a 6-month ARM fixed for the first three years, and
then it adjusts every six months
- 5/1 ARM has a fixed interest rate for the
first 5 years and then turns into a 1 Year Adjustable Rate Mortgage for
the remaining loan term
- 5/6m ARM features a fixed rate for the first 5 years and then
turns into a 6 month Adjustable Rate Mortgage for the remaining loan
term.
- 7/1 ARM has a fixed interest rate for the first 7 years
and then turns into a 1 Year Adjustable Rate Mortgage for the remaining
loan term
- 7/6m ARM features a fixed rate for the first 7 years and then
turns into a 6 month Adjustable Rate Mortgage for the remaining loan
term.
- 10/1 ARM features a fixed interest rate
for the first 10 years and then turns into a 1-Year Adjustable Rate
Mortgage for the remaining years.
- 10/6m ARM has a fixed rate for the first 10 years and then
turns into a 6 month Adjustable Rate Mortgage for the remaining loan
term.
Historically, lenders offered, and may again, true 3-year and 5-year
ARMs that only changed every three or five years over the term of the
loan.
ARMs can be borrowed on an interest-only (usually at slightly higher
rates) basis, or fully-amortizing Principal and Interest.
Caps are limits to how much an Interest Rate can change, and are expressed
by defining that maximum change at three points in the life of the loan:
- at the initial/first change
- at subsequent adjustments
- and over the entire life of the loan
For example, “caps” of 5/2/5 would mean a maximum rate change of
- 5% at the first adjustment
- 2% change at subsequent adjustments
- and no more than a 5% change at any adjustment during the life of
the loan
Caps can be different for each and every kind of loan, again, they’re
one factor in the yield calculation used by the lender to determine the
pricing of the loan.
Payment Capped/Negatively Amortizing ARMs
An ARM can also be written without caps, which can be risky to the
borrower, and/or they can have a “payment” (only) cap instead of a rate
cap. A payment cap is a limit to how much the payment can change, from
year to year, and is expressed as a percentage of the P&I or IO payment
amount, i.e. most “negatively-amortizing” loans have payment caps of 7.5%,
thus a $1000.00 monthly payment can’t exceed $1,075.00 in the next year.
If a loan is payment capped, it will be negatively-amortizing, which means
that when the lender charges a higher interest rate than the minimum
payment pays, the unpaid interest is added or “deferred”, to the balance,
such that the balance of the loan goes up. Most
negatively-amortizing loans have a mandatory “recast” period when the
payment has to change. This is based on the increased loan
balance, regardless of the normal payment caps, i.e. all caps are off at
that recast change.
If a loan is rate-capped, it can’t be a negatively-amortizing loan, as the
borrower must pay the entire interest cost.
Is an ARM Right for You?
As you can see there are numerous types of ARMs. Finding one with
terms that your comfortable with can help you by lowering your payments
and helping you to qualify for a larger loan. You'll also want
to remember that while your initial loan may be an ARM you can refinance
later and change to a fixed mortgage as your circumstances change.
We hope this article helps you understand the wide variety of choices
that you have with Adjustable Rate Mortgages. If you have any other
questions or you'd like to see if an ARM is right for you don't hesitate
to contact us.
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